If there is one metric that investors normally use to evaluate the financial profitability of a company, it is the Return on Equity ratio or ROE.
The ROE, which is calculated by simply dividing a company’s net income by its stockholders’ equity, is used to measure how well management is using investors’ money to generate profits.
The higher the ROE, the more efficient management is at deploying company’s resources.
A high ROE indicates that a company has a superior ability to create profit without needing so much capital.
A rising ROE may mean higher growth for the company, but how effective is ROE in predicting stock returns?
If we run a simple correlation between the P/E ratios of PSE index stocks and their historical ROEs, we will find that there is hardly a direct relationship between ROE and stock returns at only 0.1 percent.
This weak link means that an increasing ROE does not necessarily lead to a higher share price.
One reason why ROE may not be a good predictor of stock returns is because the ratio does not reflect the real earnings power of a company.
Remember that earnings come from assets that are financed by both debt and equity.
In ROE, we only use the portion of the earnings that is attributable to equity investors, which is net of all non-operating costs, including interest expenses.
Imagine a company that finances most of its assets by debt can possibly boost its ROE if it makes more than the cost of financing.
On the other hand, it may also be difficult to judge a startup company that generates low ROE just because it uses most of its earnings to pay interest expenses without looking at its overall profitability.
The ROE may also be vulnerable to creative accounting. For example, a company can artificially boost its ROE by simply writing down its bad investments from its assets, which lower the value of its equity.
A company can also buy back its shares in the market to increase its ROE.
A share buyback, which is recorded as treasury shares in the balance sheet, is a deduction to shareholders’ equity.
When the value of shareholders’ equity goes down, ROE can go up without necessarily increasing its net income.
So how do we measure investment return with less distortions?
An obvious approach is to use both debt and equity as total capital of the company since they are the source of financing its total assets.
But the difficulty with this method is that not all assets in a company are contributing to operating income. For example, the interest income from cash balance is not part of operations.
The company may also have investment in properties for future development, which may not be earning yet but already funded by shareholders.
The same also with intangible assets such as goodwill, which may not be directly contributing to operating income but already paid by the company.
So, to reflect a more realistic returns, an alternative way is to use the net working capital and fixed assets, which are the main operating assets of the company, as capital base.
Instead of net income, we shall use the operating profit or EBIT, which stands for Earnings Before Interest and Taxes to derive the Return on Capital or ROC.
Like ROE, ROC is used to measure the profitability of a business but with much improvement.
ROC allows us to look at earnings of tangible capital employed in the business regardless of its debt and equity structure.
Because returns are measured directly from operating assets, ROC tends to be higher than ROE.
The median ROC of the market, as represented by PSE index stocks, is currently at 28 percent, which is more than double its ROE at only 11 percent.
Interestingly, ROC has better correlation with stocks returns at 6.6 percent. If we add the growth in operating profit into the equation, the positive correlation becomes stronger at 9.2 percent.
While ROC may seem more effective than ROE in identifying potential value stocks, bear in mind that ROC is just one of the many factors that make stock selection successful.